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JDS Uniphase's Growth Continues

By Phil Weiss (TMF Grape)
February 15, 2000

For me, this is a great time to be a Rule Maker Portfolio manager. That's because last night we announced that we're adding two dynamic companies to our stable -- Finnish based Nokia Corporation (NYSE: NOK), our first foreign based multinational, and fiber optic component maker JDS Uniphase (Nasdaq: JDSU). In fact, we went ahead and ushered both companies into the stable this morning. We purchased 17 shares of Nokia at $190 and 16 shares of JDSU at $201.50. It's always enjoyable for me to have new and exciting companies to talk about on a regular basis in our nightly reports.

In that vein, tonight I'm going to briefly recap the second quarter results of one of our two new Makers. In late January, JDSU announced its second quarter results.

What I'd like to do first is take JDSU through the quantitative elements of our ten basic Rule Maker criteria and see how things shake out. Then I'll wrap up with a few of the other highlights from the quarter.

1. Sales growth of 10% or more on a comparable quarter basis -- JDSU's top-line revenues are growing at a rate that puts it among the top tier of public companies. Its year-over-year sales growth came in at 119%. Its sequential quarterly growth of 25% easily passed our 10% target as well. Even if the impact of current acquisitions is excluded, JDSU grew revenues by more than 100% over the year-ago figure.
   
   JDSU also raised its expectations for sales growth in the coming year to well over 100% and said that it expects sequential revenue growth of 25%, which is double the 10-12% that it expected previously. JDSU is currently growing at industry-leading rates off a much higher sales base than its competition. At this point in time, the expansion of its business is limited much more by capacity constraints than by demand.
   
   It should also be noted that during the quarter 22% of JDSU's sales were to Lucent Technologies (NYSE: LU) and 14% were to Nortel (NYSE: NT). No other single customer accounted for more than 10% of JDSU's sales.
   
   
2. Gross Margins of 50% or more -- JDSU's gross margin for the quarter improved slightly to 50.7% from 50.1% a year ago. There are two elements of the manufacturing process that are presently holding back JDSU's gross margins. One is manufacturing efficiency. JDSU needs to improve upon its operational performance, as it does not get nearly the same yield as a company like Intel. If it can improve upon its efficiency, it can create an insurmountable lead over its competitors.
   
   The other area with room for improvement is that at present JDSU sells many of its products on a stand-alone basis rather than in modular form. One of the efficiency keys related to manufacturing products like those made by JDSU is packaging. This refers to the ability to take a laser chip from a wafer, couple fiber to it, adding any other devices that are needed and making a complete product. As a point of reference, I recall reading that one of our other portfolio holdings, Intel (Nasdaq: INTC), was able to significantly improve the margins on its low-end Celeron chips via its new flip chip packaging.
   
   According to JDSU's SEC filings, gross margins may also be constrained by the competitive nature of its markets and downward price pressure on the products that it sells.
   
   
3. Net Margins of at least 7% -- On a pro form basis (i.e. excluding acquisition-related charges such as amortization of purchased intangibles and acquired in-process R&D), JDSU improved its net margin by 2% (from 21% to 23%). JDSU's net margin is helped to a certain extent by its dynamic rate of growth. For example, its target for the ratio of research and development expense (R&D) to sales is in the 8-9% range. It is currently at only 7.7% as the company is having trouble keeping R&D growth in line with its explosive sales growth.
   
   
4. Cash-to-Debt of 1.5 or greater -- JDSU has a debt-free balance sheet. This is in line with CEO Kevin Kalkhoven's goal of being able to finance growth through cash provided by operations. That's music to a Rule Maker investor's ears.
   
   
5. Flow Ratio of 1.25 or less -- This is the one area that JDSU falls a bit short of our expectations. Its flow ratio for the current quarter was 1.54, which was a 5% decrease from last year's 1.63 figure, and -- more importantly in the case of JDSU -- down 11% from last quarter's 1.74. Normally we like to look at year-over-year figures instead of sequential ones. However, one of the difficulties with evaluating this number for JDSU is the massive number of acquisitions that it has completed over the last year, highlighted by last June's combination of Uniphase with JDS Fitel. Due to the substantial changes to JDSU over the last year and the lack of availability of pro forma balance sheet information for the merged entity, right now I believe that it is better to look at quarter-to-quarter movements on the balance sheet instead of year-over-year. The mid-quarter acquisitions that JDSU has made also are likely to have had an impact on JDSU's balance sheet.

There are a couple of elements on JDSU's balance sheet that we plan to keep an eye on in the future. The first is its management of accounts receivable. Days sales outstanding (DSO) -- accounts receivable / (sales/90) -- increased by 4 days to 59 from last quarter's 55. JDSU has also been building its inventory for certain product categories, which resulted in an increase in its days inventory outstanding (DIO) -- inventory / (cost of sales/90) -- from 70 to 87 days. On the positive side, our company's days payable outstanding (DPO) -- accounts payable / (cost of sales/90) -- increased from 37 to 48 days. All in all, JDSU's cash conversion cycle (DSO + DIO - DPO) increased from 88 to 99 days.

We fully expect that JDSU's flowie will come down in the future as it improves the quality of its balance sheet and its operations while also extending its dominant position in the marketplace.

There are a couple of other issues that I would like to discuss briefly before wrapping up this report. The first is that JDSU's main areas of focus at present are as follows:

• Ramp up its manufacturing capacity.
• Continue to invest strongly in R&D in order to develop its next generation components.
• Continue its focus on integrating components into modules.

The two biggest concerns for JDSU at present relate to the question of having enough manufacturing capacity to meet demand and the company's ability to improve its operational performance and create an insurmountable lead over its competition. Its recently agreed upon acquisition of E-TEK Dynamics (Nasdaq: ETEK), should help it better address these issues. If JDSU is able to successfully address its concerns, then it could well continue to exceed investor expectations.

If you're interested in learning more about this fine company and its future prospects, you may also find the following to be of interest:

• Electronic Business: Who will be the hot CEOs of the next century?
• Robertson Stephens: Next Generation Networks First Mile Archive

Phil (TMFGrape on the boards)

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